Trump and his GOP allies could roil markets this fall

Traders worry about low volatility in financial markets, a possible sign of complacency as overvalued stocks hover near record highs. If they’re looking for more turbulence, they may be about to get it.

President Donald Trump and his GOP allies in charge of Congress have some important business to conduct in a short period of time once they return from a long summer recess in early September. First they have to raise the federal debt ceiling, so the U.S. government can continue to borrow the money needed to pay its bills. Then they have to pass legislation to fund the government beginning Oct. 1, the start of the new fiscal year.

This is the most basic business of government — keeping itself solvent and open for business. It ought to be pro-forma — but of course it’s not. And the Trump presidency could produce the extraordinary spectacle of one political party at war with itself, creating needless economic turmoil when it ought to be unifying in pursuit of shared goals.

Most senior Republicans say the only responsible path is to raise the debt ceiling and fund the government in short order, so they can move on to tax cuts, a longstanding Republican priority. The president himself is the wild card. Trump recently said he’d trigger a government shutdown if he can’t get $1.6 billion to start building his Mexico border wall, a project Republican appropriators aren’t eager to fund. And Trump continues to pick fights with Senate Majority Leader Mitch McConnell and other key Republicans, sowing division within his party rather than harmony. All this suggests nothing will go as smoothly in September, as it should.

Congress needs a little nudge

Investors tend to think that no matter how ugly the politics get in September, it will all work out in the end. The key question may be, at what cost? “We don’t think it will be easy, or smooth,” Morgan Stanley told clients in a recent note. “It may require some form of market pressure to get different sides to fall in line.”

“Market pressure” means distress in financial markets that gets Washington’s attention and compels them to stop screwing around. CEOs may warn the White House that business is weakening and economic risks are rising. One vivid example of this was the 7% plunge in the stock market on Sept. 29, 2008, when Congress failed to pass a bank-bailout bill amid the financial crash. Congress got the message and passed a lightly revised version of that bill a few days later.

We’re not in the midst of a financial crash, which is obviously reassuring. But there are also parallels to August 2011, when an impasse over raising the debt ceiling led to a real threat of default on U.S. debt and a last-second resolution. Following that shabby episode, Standard & Poor’s lowered the U.S. credit rating by one notch, for the first time ever, citing political dysfunction as the cause. Stocks fell 6.7% in one day, and it took more than six months to regain that summer’s market peak. The VIX index, which is around 12 now, hit 43, its highest level since the bottom of the market crash in early 2009.

Influence of the political divide

One difference between 2011 and now is that divided government back then pitted Democratic President Barack Obama against a Republican-controlled Congress. Bitter political divisions nearly overcame common sense. That shouldn’t be a problem now, with both branches controlled by Republicans. Except Republicans have become as fractious as two different parties.

The upcoming budget battles will play out in familiar fashion. Establishment Republicans will try not to rock the boat, while hard-line conservatives whose votes are needed will try to use their leverage to extract spending cuts and other concessions the centrists refuse to grant. Democrats, whose votes will also be needed, are learning to just sit on the sidelines and let the Republicans bicker. But they’ll have leverage too, and they could throw a wrench into the budget plans as well, if they can do it while avoiding blame.

Volatility in markets isn’t inherently bad. It can rationalize valuations, ground unrealistic expectations and provide buying and selling opportunities for those so inclined. But political uncertainty can generate a kind of artificial volatility that wouldn’t exist if the government were managed better. Traders shouldn’t be making bets on the degree of incompetence in Washington. However, that’s exactly what they’re doing.